Disclosures in Complex Transactions

With increasing complexity in transactions entered into by companies, especially in the financial sector, there is the lingering question of how these transactions are to be meaningfully disclosed to shareholders of the companies so as to enable them to take an investment decision (such as to buy, sell, hold, etc.). The trouble here is that institutional investors themselves are unable to appreciate the real nature of these transactions. We have seen some of this in the sub-prime crisis when several such investors bought collateralized debt obligations (CDOs). How then does one expect lay investors to grasp the intricacies involved in these transactions when they happen to be shareholders or other security holders in any of the companies that are parties to such deals?

In Going beyond Greek letters in Livemint, Amol Agrawal flags the issue by giving the example of the UBS annual report that was sent to its shareholders:

“Swiss bank UBS AG has recently released a report where it has tried to explain to shareholders what went wrong in the subprime crisis. UBS is one of the worst affected firms and the decisions of its managers needed explanation. The report is an honest admission of various judgemental errors by the management.

One wonders how many of UBS’ shareholders understood what was written. It sounds Greek all the way. There is a surfeit of jargon and acronyms. One has to continuously flip back the pages to understand the chain of events.”

He then goes on to deal with some of the policy implications that lay behind disclosures and complex financial transactions:

“All this poses numerous problems for the policymakers. They have to not only develop their financial systems, but also make them more crisis-resistant. Take the India example. There have been numerous reports on India’s financial sector. All these committees/reports suggest the same —an efficient financial system with more participation of public and encouraging financial innovation. But then, we can’t really ignore the risks from these fancy financial products. The UBS-type shareholder reports might soon be written by Indian firms (I hope not in times of crisis) and the recent derivatives crisis suggests the time will come sooner than later. How many shareholders will actually understand these derivative positions? If they don’t, then the purpose of bringing more public savings into capital markets needs to be questioned.

The subprime crisis has pointed to the need for financial literacy, but understanding what happens in financial markets requires much more than basic financial literacy. Even the best financial brains can’t figure out the developments. Hedge fund Long Term Capital Management (LTCM) failed miserably despite having Nobel-winning economists on board. The subprime crisis is a collective failure of many such minds.

There is an urgent need to tackle the perverse incentives and complexity in the financial system. The regulators alone can’t do the job and the participants will have to become responsible themselves. But then, we are all interested in our yachts, who cares for the customers/shareholders? Financial deepening without creating financial excesses (as said by Hervé Hannoun of the Bank of International Settlements) is the need of the hour. The focus so far has been on the first part. The sooner we move to second, the better it will be.”

The observations in the article are interesting. Disclosures relating to complex transactions will always result in information asymmetry. However, that just seems to be a fact that one cannot wish away. It is almost impossible to provide these disclosures in simple terms that are comprehensible to a lay investor. If at all that is attempted, there is a sure risk of oversimplification that may alter the meaning, relevance and importance of that information. Therefore, the option of providing simple disclosure that lay investors understand may not be a viable option.

As Steven Schwarcz notes in his article Rethinking the Disclosure Paradigm in a World of Complexity, what we have is a “dilemma that some structured transactions are so complex that disclosure to investors of the company originating the transaction is necessarily imperfect – either oversimplifying the transaction, or providing detail and sophistication beyond the level of even most institutional investors and securities analysts.”

This then means that disclosure is not the proper means to regulate complex financial transactions. Such transactions must either be restricted by law and regulation, or alternatively such complex investment opportunities must be made available only to sophisticated investors (e.g. qualified institutional buyers) and not to those who cannot understand and appreciate the full extent of the risks they may be taking with these investments. This must, of course, be weighed against the need for vibrant financial markets that encourage financial innovation – always a tough balance.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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